To Invest in Real Estate

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1 Using Your Retirement Plan To Invest in Real Estate This book is for informational purposes only and does not serve as a substitute for tax or legal advice.

2 Table of Contents INTRODUCTION... 2 REAL ESTATE AS A RETIREMENT PLAN INVESTMENT... 2 PURCHASING THE INVESTMENT... 3 TYPES OF REAL ESTATE ALLOWED... 3 FINANCING A REAL ESTATE PURCHASE... 3 PURCHASE STRUCTURES... 4 THE PROCESS: FLOW CHART... 5 THE PROCESS: STEP-BY-STEP... 5 OWNING REAL ESTATE IN AN IRA... 7 INCOME AND EXPENSES... 7 MANAGEMENT OF ASSET... 8 CASH SHORTFALLS WITHIN THE IRA... 8 RULES... 9 PROHIBITED TRANSACTIONS & DISQUALIFIED PERSONS... 9 CONSEQUENCES AND PENALTIES SELLING IRA-OWNED REAL ESTATE IMPORTANT THINGS TO KNOW AND REMEMBER UTILIZING A PROPERTY MANAGEMENT COMPANY UNRELATED BUSINESS INCOME TAX (UBIT) CASE STUDIES CASE STUDY 1: UNDEVELOPED LAND CASE STUDY 2: PARTNERING WITH IRA WITH CASH CHOOSING THE SELF-DIRECTED PLAN THAT BEST FITS YOUR INVESTMENT STRATEGY Traditional or Roth - Which To Choose? TRADITIONAL IRA ROTH IRA SEP IRA SIMPLE IRA HEALTH SAVINGS ACCOUNTS (HSA) EDUCATION SAVINGS ACCOUNTS (ESA) INDIVIDUAL (K) PLANS HOW TO CHOOSE A CUSTODIAN OR ADMINISTRATOR ABOUT THE AUTHORS Catherine Wynne and Bill Humphrey Principals of Entrust New Direction IRA APPENDIX A IRS CODE SECTION 4975 PROHIBITED TRANSACTIONS APPENDIX B INSTRUCTIONS FOR TITLE COMPANIES AND REAL ESTATE BROKERS.. 31 APPENDIX C IRA/401K PLAN CONTRIBUTION LIMITS APPENDIX D GLOSSARY

3 INTRODUCTION Real Estate as a Retirement Plan Investment The key to the self-directed retirement plan is the flexibility to place any legal investment in your Plan, including real estate. Purchasing real estate in your Plan provides investors a hard asset to counterbalance the retirement portfolio traditionally dominated by financial securities. It also allows real estate investors the ability to invest in an asset that they know and understand. Self-directing retirement funds to real estate requires having a plan that allows true self-direction. Many financial institutions, while promoting self-direction, allow only financial securities to which the institution has easy access or from which it earns commissions. Truly self-directed plans allow you, the investor, to select the investment on your own. Self-directed plan administrators may be located easily via an Internet search. Entrust New Direction provides investors with education and hands-on assistance in self-directing their plan. Once your Plan or Account is established, you may direct your plan administrator to purchase for your Plan whatever real estate property you choose, within IRS guidelines. As with any IRS-related pronouncement, there are exceptions. When purchased, the property becomes an asset of your Plan or account. In addition: You do not personally own the property purchased by your Plan You must ensure that your intended purchase is not a prohibited transaction. A prohibited transaction involves the improper use of your IRA or Qualified Plan holdings by you or any disqualified person. A disqualified person is any member of your immediate family (except siblings), employers, certain partners, fiduciaries, and other categories specified in the IRS code. (See Appendix A) The property must be for investment purposes only. Neither you, your spouse, nor your family members, other than siblings, may have owned the property prior to its purchase by your Plan. Neither you nor your family members (other than siblings) may live in or lease the property while it's in your Plan. Your business may not lease or be located in or on any part of the property while it's in your Plan. 2

4 A more detailed examination of the IRS rules governing the purchase of real estate by an IRA or qualified plan is included in the Rules Chapter of this e- book. PURCHASING THE INVESTMENT Types of Real Estate Allowed Nearly any kind of real estate is permissible as an IRA investment. The IRS code specifies no restrictions on: Types of Real Estate How long the property is held Where the property is located The price and/or market value of the property The following are all possible investments for your IRA or Qualified Plan: Single family homes Commercial Property Multi-unit homes Rental properties Apartment buildings Fix & Flips Condominiums Improved or unimproved land Co-ops Property held only for appreciation Entrust will not provide investment advice regarding the purchase, they only perform the actions that you direct. As administrator, Entrust follows your instructions, reviews documents, and signs purchase and other documents on behalf of your Plan. Ultimately, both the IRA and investment control belong to you. Financing a Real Estate Purchase If your IRA does not have enough funds to purchase the property of choice, there are some options to consider for coming up with the balance for the investment. You may have your Plan partner with other plans or other individuals to make a purchase. You are allowed to finance a portion of the price if you wish. Your Plan may invest in a partnership or LLC that is purchasing real estate. The choice is yours. The ability to put your retirement funds into an investment that you can see, select, control and understand is the power of self-direction. 3

5 Purchase Structures 100% Cash Property may be purchased with cash from the plan. This is the easiest way to purchase property with your IRA. In this case, the IRA owns 100% of the property. Partnering The IRA may partner with another person, entity, or IRA. In partnering, your IRA would own only a percentage of the property and the remaining portion would be owned by someone else. It is acceptable to partner your IRA with personal funds and/or disqualified persons, but one should take care in doing so. When partnering with disqualified persons, the ownership percentage must be kept constant throughout the deal, and all expenses as well as income, must be split according to that ratio. It is also important that the dollar amounts be proportional to percentage of ownership when partnering with disqualified persons for the life of the investment. Managing the funds for this type of partnering is difficult, as it requires a third party property manager or bookkeeper to handle the monies of the property. Mortgage The IRA may use leverage (a mortgage loan) to purchase property. The loan must be a non-recourse loan, meaning that the IRA holder does not guarantee the loan, or pledge their personal assets and/or credit; the only security on the loan is the property itself. Non-recourse loans are typically made on incomeproducing properties and require between 35-40% down. Profits from the leveraged portion of the investment may be subject to UBIT (Unrelated Business Income Tax). Please refer to our report on UBIT for more information. LLCs LLCs are not required to purchase real estate within an IRA this is a common misconception. Although some clients do use LLCs to purchase real estate, a majority of IRA-held property is held directly in the IRA s name. When property is held directly by the IRA, paperwork flows through the hands of the Administrator, who ensures all paperwork is correct and transactions are clean from observable prohibited transactions. This benefit is lost in an LLC as transactions within the entity are invisible to the Administrator. An LLC with IRA owners is still bound by IRS rules related to IRAs. It is the LLC manager s responsibility to avoid prohibited transactions which, if violated, can result in the distribution of the IRA plus other penalties. It is the client s 4

6 responsibility to ensure that the manager is familiar with IRS code section 4975, the 5305 disclosure document, and has competent legal advisors. The Process: Flow Chart Paperwork IRA Purchases Real Estate Client Opens Self-Directed IRA Client transfers Funds from current Custodian to Self-directed IRA Client/broker Finds Property Client performs Due diligence On Property Paid for by IRA Title Company Produces Closing pkg. Offer made & Accepted, IRA funds Earnest money After Client issues Buy Direction Ltr. Client reviews & app clsg. docs & instructs Administrator To fund closing Broker Writes contract With Buyer as IRA, signed by Administrator Custodian Signs clsg docs & funds clsg. Deed recorded. The Process: Step-by-Step 1. Opening the account with the self-directed administrator is the first step because the administrator must be authorized by the client to sign the sales contract. 2. Funding the account should quickly follow account opening. Funds transfer may take as little as 3 weeks or up to several months depending on the client s custodian. Having the funds distributed to the client and rolled over into the new self-directed account is the fastest way to fund the account. However, there are restrictions on how often this can be done. 5

7 Opening and funding the self-directed IRA prior to making any offers on investment real estate will ensure that your purchase is completed quickly and with the least difficulty. 3. Finding the property is the next step. The broker must advise the client on suitability of the purchase based on the IRA account s ability to purchase and pay ongoing expenses, if necessary. 4. The IRA Administrator, Entrust New Direction, Inc. must sign the contract on behalf of the client s plan. If the IRA holder is unable to get in touch with the Administrator on weekends or after hours, other arrangements will have to be made. Writing the contract correctly (as always) is one of the most important steps in this purchase. An example of proper titling of the buyer: Entrust New Direction, Inc. FBO John Smith, IRA. Note: there may be other titling options that are specific to certain custodians or administrators. 5. The earnest money check must be written from the IRA account. Always check with the administrator/custodian in order to find out what their guidelines are. Keep in mind that if funds transfer is an issue when needing quick earnest money, you can always make your current year IRA contribution in order to have funds available. 6. Due diligence is the responsibility of the client, the IRA holder and the broker, to the extent specified in agency law. Expenses incurred for inspections, surveys or other items are best paid at closing and shown on the settlement sheet. The expenses may also be paid for by a nondisqualified person. NOTE: The self-directed IRA administrator may NOT at any time issue a check to the IRA holder as that would be considered a distribution and therefore subject to taxes and possible penalties. 6

8 7. The IRA holder must coordinate the details of the real estate purchase. The title company will work closely with the IRA administrator, with assistance from the IRA holder, in order to correctly produce the documents for closing. Leave time for changes to documents. Make sure the title company has received instructions (see Appendix D) and that this closing will not be attended by the administrator for the IRA. This means that documents need to be ready at least 48 hours before the closing date because it will be a mail out closing. 8. The client/ira holder must always review and approve the settlement documents prior to closing. An indication that the documents have been read and approved is required before the Administrator will fund the transaction. How is this indication made? The IRA account holder reads and approves the documents by signing and dating the documents and including the statement read and approved on the signature pages. The Administrator will always sign on the buyer line, not the IRA holder. 9. The Administrator reviews all documents for correct and consistent titling. The address of the Buyer is the address of the Administrator. The Taxpayer ID number is the Administrator s trust account tax ID. 10. Closing and funding the transaction is done after the client has officially directed the Administrator in writing. Administrators will always have a form for this, called a Buy Direction Letter. OWNING REAL ESTATE IN AN IRA Income and Expenses Once the purchase has been completed, all expenses and income will flow in or out of the IRA account. For example, the property tax for the property will be paid by the IRA. Any rental income would be made payable to the IRA and would be deposited into the IRA account as investment earnings. This arrangement is critical for protecting the tax advantages of the IRA-owned real estate. 7

9 If you personally pay an expense for the IRA, that expense becomes an over contribution to your plan. Taxes, as well as IRS penalties, may apply. It is the client s responsibility to ensure that all bills/invoices are mailed or faxed to Entrust. Management of Asset Following the closing, the client must have a plan in place that covers the ongoing management of the property. Since the client may not handle any monies associated with the property, a third party who is not a disqualified person must handle the day-to-day business. Options for this third party would include: Professional property manager using a trust account Bookkeeper with a business account set up for the property Accountant Self-directed Administrator to write checks only. NOTE: IRA holder may take possession of checks from the tenant if the checks are made out to the Administrator and if the IRA holder forwards them directly to the IRA account. Real Estate broker with business account Trusted Non-disqualified person If there is a management contract, remember that the IRA is the client of the property manager and therefore the administrator must sign the management contract. Make sure the property manager understands that the IRA holder may not receive any funds from the IRA account under any circumstances. This concept is sometimes difficult to absorb at first exposure, so encourage the manager to contact the Administrator if there are any questions on the financial arrangements. The property manager is required to send current financial reports to the Administrator quarterly. Cash Shortfalls within the IRA Your IRA is responsible for all expenses related to your investments, including any emergency expenses like a new roof or new appliances. Even though you expect your tenants to pay rent, and you make sure to make a maximum contribution each year, it is possible for an unexpected expense to put you in a tight situation. You must plan for contingencies and maintain reserves of cash in your IRA account. Never use all of the cash in your account for the purchase of the asset; you will most likely need some later. To cover some of those emergency purchases, IRAs may purchase hazard insurance, and, if used, the money paid out for claims must go into the Plan and 8

10 be paid to contractors. These funds may also be used as a withdrawal of an excess contribution. Overall, the safest thing to do is to think ahead and keep enough liquid funds in your IRA to cover emergency expenses. Please be sure to call your IRA administrator if this becomes an issue. RULES The most frequently asked questions about self-directed retirement plans are about which kinds of transactions are permitted, and which are not. How much freedom do you have when it comes to investing with your tax-free or taxdeferred IRA? The IRS tax code addresses this question by outlining and defining what is prohibited. Self- dealing transactions are prohibited. The terms "self-dealing" and "prohibited transaction" may be used interchangeably. There is little in the way of guidance or direction regarding what is allowed, in specific terms. Therefore it is important to understand the basic intent of your retirement plan, and the language that defines prohibited transactions. Fundamentally, your retirement plan is intended to benefit you when you retire, and not before then. This simple concept is helpful in understanding the rules on permitted uses of your IRA. If you are planning any transaction which clearly appears to confer direct benefits to you prior to retirement, you should carefully examine the legality of such a transaction. Prohibited Transactions & Disqualified Persons IRS rules prohibit the IRA from dealing with certain people. Disqualified persons to your Plan are: You Your spouse Your ascendants (parents) Your direct descendants (children) Your direct descendants spouses Certain fiduciaries (CPAs, Attorneys, Financial Planners, etc.) Retirement Plans held by disqualified persons 9

11 Entities owned or controlled by disqualified persons A disqualified person CANNOT: Buy a property/asset from the Plan Sell a property/asset from the Plan Live in this property Rent this property (even if paying fair market rent) Use the property personally as a vacation home Pay expenses for the property Handle money related to this property Make improvements to this property Guarantee a loan or extend credit to the IRA Take a commission on the purchase or sale of this property Put personal property or sweat equity into this property In other words, if the IRA directly or indirectly benefits OR is benefited by a disqualified person, that action is a Prohibited Transaction. Consequences and Penalties It s important to be aware that a violation of transaction rules may result in the distribution of this asset from your plan and may cause you to incur severe penalties. This rule is defined in IRS Code, Section 4975 (See Appendix A). SELLING IRA-OWNED REAL ESTATE Selling a property owned by an IRA may result in an increase in the IRA account value, which is tax-deferred when the entire transaction takes place within the account. Funds from a liquidated property may be invested in anything allowed by IRS Code section 408, including more real estate. When selling a property that is owned by an IRA, the process is very similar to initially purchasing the property. The process: 1. Listing Contract is with the IRA, not the owner of the IRA. The Seller line should read exactly the same as the Deed. Although the beneficial owner of the IRA should acknowledge that they have read and approved the listing agreement, it will need to be ultimately signed by the IRA Administrator. 2. The IRA holder AND the Administrator should sign other documents such as the Lead Based Paint Disclosure, Property Disclosure, Square 10

12 Footage Addendum and others. The Administrator s signature on these documents is for acknowledgment of the document only, and is not meant to convey any knowledge or responsibility for the property condition. 3. Once the property is under contract, the Sales Contract and any addendums or amendments need to be signed by both the IRA holder as read and approved and by the Administrator on behalf of the IRA. 4. If there is a loan on the property, the IRA holder or the IRA administrator should provide information to the title company on the mortgage payoff. 5. Title work should be sent to both the IRA holder and the IRA administrator although it is the IRA that is the owner of the property. 6. Once the property is under contract and the Buyer s due diligence has been performed, the broker needs to work with the title company in preparation for the closing, ensuring that all documents have the correct vesting of title. 7. The IRA holder needs to review anything that is signed by the Administrator, ideally at least 48 hours prior to the day of closing. Since the Deed is the most important document in the closing, the buyer s broker and the Administrator need to examine this document to ensure that the entity shown as conveying the property is correct. Do not hesitate to seek competent legal advice if there are any questions about the conveyance. The Deed will need to have the Administrator's signature notarized; therefore, it will be a mail out closing, and the document should be reviewed by the Administrator prior to sending in order to avoid delays. 8. At the time of the closing, the proceeds of the sale must go back to the IRA. The IRA Administrator needs to account for the sale of the asset on the books. If there is a lender and there are funds in the lender s escrow for real estate taxes or insurance, the lender will need to be reminded that those funds MUST be sent to the IRA administrator and NOT be sent or made payable to the IRA holder. 9. If there are any escrow agreements or holdbacks for work on the property, they need to be signed by the IRA Administrator. 10. If the property had a mortgage, there is likely to be UBIT generated on the sale of the property. Just like when the investment is initially made, care should be taken when deciding when to sell a property, taking into consideration the affect of UBIT on the proceeds of the sale. Note: although not covered here, it is possible to perform a 1031 exchange on the debt-leveraged portion of the sale in order to avoid the tax. In order to avoid self-dealing or other prohibited transactions, the following also needs to be observed: 11

13 No cash from the sale may go back to the IRA holder A Broker who owns a property in his/her IRA may not earn a commission from the sale of the property. No Disqualified Person may purchase the property. This includes an indirect purchase that involves sale to a third party and quitclaim or quick sale to the IRA holder. The sales transaction must be a real transaction, not merely a change in title for the purposes of getting the property out of or into the IRA. IMPORTANT THINGS TO KNOW AND REMEMBER IRAs require special treatment and have to follow specific rules. The first investment will be on a learning curve, and the administrator expects to answer a lot of your questions. Please remember: 1. You and your IRA are NOT the same thing. a. Your IRA is a completely separate entity from you - think of it as your Uncle IRA. b. You cannot sign on behalf of your IRA - If something needs a signature, write Read and Approved and sign IN THE MARGINS; then, /fax to us to sign as the buyer or investor. 2. You may NOT pay any of the IRAs expenses. a. The IRA cannot reimburse you. b. Any expense of the IRA s that you pay becomes a taxable and penalized distribution from the plan - this INCLUDES earnest money. 3. UBI Tax applies to profits made as a result of using leverage (loans). a. It is the client s responsibility to calculate, report, and pay this tax. 4. Any violation of IRS rules that results in a Prohibited Transaction will result in the distribution of related funds plus penalties. 12

14 Utilizing a Property Management Company If you choose to use property managers to make the process of paying bills and collecting rent quicker and easier, please note these requirements. The property management account must be in the name of the IRA. The property managers must provide the IRA administrator an accounting of the income and expense on a quarterly basis. Any excess cash would be sent from the property manager back to the IRA. Property managers must not be disqualified persons. Unrelated Business Income Tax (UBIT) If you elect to take advantage of debt financing to make the purchase, you should be aware of Unrelated Business Income Tax (UBIT). Basically, UBIT is tax on the income produced by the debt-financed portion of your investment. Your plan administrator will be able to direct you to appropriate information regarding the UBIT calculation for your proposed purchase. Once the property is purchased, all the expenses and debt service payments will have to be paid through your Plan. You must make sure that there are sufficient funds available in the Plan on an ongoing basis. If you prefer, you may hire a management company to receive the rents and pay the bills, or you can arrange for those functions to be handled by the Plan administrator. If you decide to sell the property, once again you direct the administrator to complete the transaction upon your direction. The proceeds from the sale are put back into your Plan. The administrator can also be directed to distribute the property to you, in part or in whole as a distribution from the plan. This option is a favorite for investors who wish to personally use property in the Plan, such as a retirement home, once they reach the age of 59 1/2. Real estate in retirement accounts is not a new idea; Entrust has been providing self-directed IRAs since IRAs have been promoted primarily by financial services companies who do not have the expertise to provide truly self-directed plans and who are not financially motivated to develop such programs. Today, the advent of the Internet is making companies like Entrust more accessible to the average investor and the idea is spreading quickly. 13

15 CASE STUDIES Case Study 1: Undeveloped Land 10 acres with privacy, views and amenities in mountain resort community IRA makes cash purchase of property 2010 price: $50k Jake is a successful rancher in rural Wyoming. His dream is to pass the ranch and all the operations to his sons a few years after his 60 th birthday and retire to a mountain resort community. While vacationing in Whitefish, Montana Jake finds the perfect spot. He knows he s found the property of his dreams in this secluded acreage with a bubbling spring, gorgeous mountain views and a short drive from town. This year has been tough on Jake s savings. He has already borrowed as much as he can this year on emergency equipment purchase this spring. He simply does not have the personal resources to buy the property this summer. He considers giving up until he gets a call from the selling Realtor, Joe, saying the seller really needs to sell the property and has reduced the price an additional $25,000! Luckily, Joe has a helpful suggestion. Has Jake considered buying the property using his retirement savings? Joe explains that Jake cannot use the property until he retires, but the investment would grow tax-deferred until that point. Jake doesn t care about not using the property until retirement, because he would continue to live in Wyoming until retirement anyway. Jake and Joe begin by carefully analyzing the projected costs together to determine if the investment is worth considering. Jake is 40 years old this year. Joe projects that the property will be worth $100,000 in 2029 when Jake reaches age 59 ½ and can begin taking ownership of the property. Because Jake would like to retire on the acreage, Jake plans to distribute ownership in lieu of cash distributions from the retirement plan for his first few years in retirement. Option 1: Take 100% distribution of ownership in Pay income tax on the $100,000 value of the distribution. Jake plans to continue working and live on income from his ranch of $60,000/year in Adding the $100,000 distribution to the ranch income puts Jake and his wife in the 28% tax bracket for Total income tax paid on the distribution comes to $28,000. Initially, Jake balks at that figure, but Joe reminds him that he would have to grow the $50,000 in his IRA to $100,000 in order to make a cash purchase of the acreage in 2029 and chances are that by 2029 properties like this acreage will not even be available anymore. The development in the area is growing at a steady rate. Joe also points out that 14

16 including the income tax on the property ownership, total costs to acquire the property ($78,000) are still well below the projected property value in Jake agrees they should continue the analysis, but more questions are growing in his mind. Jake wonders aloud, What if I don t have $28,000 to pay the taxes in 2029? What if the area gets so crowded that I don t want to live here anymore once I retire?. Whoa! grins Joe, one question at a time! Then Joe complements Jake on his forward thinking. He is planning ahead and thinking critically, which are important when making any investment. Joe begins supplying the answers Jake needs, In planning for the tax, it will be a good idea to consult with your CPA. I know there are options to spread that out, so ask how to do that. Either way, you will want to save for that expense as part of your retirement planning. Joe also reminds Jake that he always has the option to sell the acreage instead. Let s look at what Jake would earn on the land as an investment. Purchase price 2009: $50,000 Projected sale price 2029: $100,000 Costs associated with the property: $100/year tax plus 8% commission on the sale = $10000 Total profit = $40,000 Annualized Rate of Return = 4% Jake considered, Well, a few years ago I would have laughed all the way home at those numbers, but given that it means I know that land is mine after I retire, it might be worth it to me. Besides, I like the thought of having that beautiful piece of land to show for my hard work. Some of the junk I bought from my broker 3 years ago isn t worth the pig s slop bucket today. Joe got an even better idea, If you give this guy a call, we might be able to sweeten this deal. He handed Jake a business card with his CPA s name on it. If you can qualify for a Roth IRA you won t have to pay any tax on the property distribution at all. Option 2: Convert the $50,000 IRA to a Roth IRA. Take 100% distribution of ownership in Pay no income tax on the $100,000 value of the distribution. 15

17 Joe explained to Jake that if he converted the $50,000 in his IRA to a $50,000 Roth IRA by paying the 28% tax ($14000), he wouldn t have to pay any additional tax on the property when he took it as a distribution in the future. Now you re talking! said Jake. He called up Joe s CPA, Jim, to see if he could qualify. Jim was able to pass along some good news and also explain a little bit about how Roth IRA conversions work. Jake was ready to roll. Joe, it s time to write a contract. Jake was glad that Joe understood IRA purchases so well, the purchasing process went very smoothly. Thanks to Joe, Jake now knows his retirement is going to be as sweet as he s always dreamed. Case Study 2: Partnering With IRA With Cash One couple found a rental property that was, in their estimation, an incredible deal. This property in Texas was affordable, unlike just about anything in their home state of New York. The problem was they had a total of $25,000 in their combined Roth IRAs, $25,000 short of the $50,000 purchase price of the property. What could they do? Talking with lenders revealed that there would be no Non-Recourse loan available to them. The solution? This is what they did: 1. $25,000 from the Roth IRAs 2. $25,000 cash from a refinance of their personal residence in New York 3. Property deeded to the couple, as individuals, at 25% each (total of 50%) 4. Property deeded to Roth IRAs as 50% ownership Result: The couple reports 50% of the net operating income from the property, less the interest deduction for the $25,000 they borrowed with a home equity loan. IRA: the IRA receives 50% of the net cash flow from the property. NOTE: IRA must pay its proportionate share of the expenses; therefore the bookkeeping must be done correctly to avoid IRS issues. Upon sale, 50% of the net proceeds go back to the IRA; the 50% personally owned by the couple personally goes either to the couple or to a 1031 exchange accommodator. What makes this a win-win situation is that the couple has 100% leverage on their 50% share of this property as well as the interest deduction and 16

18 depreciation. The IRA, although not leveraged, has a real estate investment and the opportunity for both cash flow and appreciation at the sale of the property. CHOOSING THE SELF-DIRECTED PLAN THAT BEST FITS YOUR INVESTMENT STRATEGY Traditional or Roth - Which To Choose? An Individual Retirement Account is a personal retirement savings plan available to anyone who receives taxable compensation during the year. For IRA contribution purposes, compensation includes wages, salaries, fees, tips, bonuses, commissions, taxable alimony, and separate maintenance payments. Husbands and wives may each have an IRA, even if one person in the marriage is not employed. There are several different kinds of IRAs to meet specific individuals needs: Traditional IRA A Traditional IRA may be opened by any individual who has earned income and wants to set aside a portion for retirement on a tax-deferred basis. Contributions to traditional IRAs may not be made for the year in which you reach age 70 1/2, or any later year. If you are eligible to contribute to an IRA, the amount of the contribution for which you may take a tax deduction will depend upon whether you (or, in some cases, your spouse) are an active participant in an employer-maintained retirement plan and the amount of income you make. If you (and your spouse, if you are married) are not an active participant in an employer-maintained plan, your whole IRA contribution will be deductible. If you are an active participant (or are married to an active participant in an employer-maintained plan), the deductibility of your contribution will depend on your adjusted gross income (AGI) and your tax filing status for the tax year for which the contribution was made. AGI is determined on your income tax return using your adjusted gross income but disregarding any deductible IRA contribution. Generally, a Traditional IRA is appropriate for those who expect their tax rates during retirement to be lower than their current tax rate, or whose tax strategy is to defer taxes to a later time in their lives. Distributions are taxable and may be 17

19 subject to penalties if there is an early withdrawal. There may be exceptions for distributions used for a first home purchase or college tuition. Roth IRA A Roth IRA differs from a Traditional IRA in the sense that your contributions are made with after-tax dollars. This means that eventual distributions from a Roth IRA may be tax free. By contrast, with a Traditional IRA you pay no taxes upfront, but pay them when you withdraw the money during your retirement. Moreover, contributions can be made to a Roth IRA even after you attain age 70 1/2, and unlike a Traditional IRA, you are not forced to take distributions. A Roth IRA is appropriate for those who expect their tax rates during retirement to remain the same or be higher than their current tax rate. You can contribute to a Roth IRA if you have taxable compensation and your modified adjusted gross income is less than: Married individuals filing jointly: $176,000 for 2009 Single or head of household: $120,000 for 2009 Married filing separate returns: $10,000 Compensation includes wages, salaries, tips, professional fees, bonuses, and other amounts received for providing personal services. It also includes commissions, self-employment income, and taxable alimony. SEP IRA A Simplified Employee Pension (SEP) IRA is a plan that allows an employer, including self-employed individuals, to make contributions toward his or her own and their employees' retirement plans without becoming involved in administrative complexities. SIMPLE IRA Under a SIMPLE IRA plan, employees may choose to make tax-deferred contributions out of their salary while the employer makes a matching contribution of 3 percent each year, or, alternatively, a non-elective contribution of 2 percent of compensation. Employers must make either one or the other type of contribution, and must notify the employee before the beginning of each year which contribution type will be made. A Savings Incentive Match Plan for 18

20 Employees (SIMPLE) IRA, is well suited to small businesses. Generally, the attraction of a SIMPLE IRA is its ease of administration. Health Savings Accounts (HSA) Health Savings Accounts (HSAs) are designed to help individuals save for future qualified medical and retiree health expenses on a tax-free basis. And unlike a Medical Savings Account (MSA), an HSA is not a "use it or lose it" account. Education Savings Accounts (ESA) An Education Savings Account, or ESA, is a trust or custodial account that is designed exclusively for paying the qualified higher education expenses of the designated beneficiary of the account. The account must be designated as a Coverdell Educational Savings Account when it is created to be treated as a Coverdell (ESA) for tax purposes. Individual (k) Plans An Individual(k) plan is a cost-effective 401(k)/profit sharing plan for small business owners. The Individual(k) has 401(k)-like options for sole proprietors or small business owners. The plan offers the highest contribution amounts and lower administration fees of all plans. HOW TO CHOOSE A CUSTODIAN OR ADMINISTRATOR When you rely on an IRA custodian to handle your IRA account, you make the assumption that they know and understand the basic rules regarding prohibited transactions and disqualified persons. IRS 4975, Prohibited Transactions, gives both you and your IRA all the information necessary to manage your account legally and ensure that the rules are followed. For the purpose of this article, we are using the terms trustee, custodian and administrator synonymously. While ultimately you are responsible for following the IRS rules, what you might not know is that when using a custodian, they may be inadvertently violating the rules. The outcome is this - it is not just the administrator that will get in trouble, it is you and your IRA account as well. You could be subject to distribution, taxes and penalties as a result. 19

21 How do you know if your IRA administrator knows what they are doing? There are certain types of transactions which a custodian can never be involved in. If your IRA custodian allows any of the following, consider looking elsewhere for custodial services: Lending to your IRA Allowing you to transfer or sell anything you already own to your IRA Funding a transaction which involves a disqualified person such as a spouse, child or parent. The first example above, lending to the IRA, is unfortunately being done by bank custodians who do not understand the rules. What do you need to know about these types of transactions? If a bank is your IRA custodian, that bank may not make a loan to your IRA. IRS 4975 clearly states the following: For purposes of this section, the term prohibited transaction means any direct or indirect 4975(c)(1)(B) lending of money or other extension of credit between a plan and a disqualified person; 4975(c)(1)(C) furnishing of goods, services, or facilities between a plan and a disqualified person; What is a disqualified person? Specific to the bank custodian, 4975(e)(2) delineates the list of disqualified persons, among them: 4975(e)(2)(B) a person providing services to the plan; In plain English, any IRA custodian who provides services to your IRA, such as custodial services, is automatically a disqualified person with regards to the law. Banks who lend money to IRAs for which they are the custodian or provide investments directly to the plan, are participating in a prohibited transaction and, because it is your IRA, you are too. It may be asserted that the bank Trustee department that provides the custodial services is set up as a separate entity. If so, this entity must pass the same tests as your IRA when examining disqualified persons and the ownership of the entity providing the trust services. If the bank trustee entity is owned by the same companies or individuals as the bank providing the loan, it is still disqualified. Recent state and federal bank audits have revealed and terminated the IRA custodial services of banks who are involved in lending to their IRA accounts, mainly because of the types of transactions listed above. Many banks have decided that if they are not fully versed in the rules, they should not be in the business of providing custodial services. 20

22 Before selecting a custodian for your IRA, know what their level of expertise is. Custodians who specialize in the area of self-directed IRAs are the best selection. Having a track record, experience with a variety of transactions and competent ERISA-based legal council are a must. Remember, your custodian s error will become your error in the event of an IRS inquiry. Ask your custodian the right questions in order to ensure you are getting the most experienced custodian for your IRA and know the Prohibited Transaction yourself in order to stay in compliance. ABOUT THE AUTHORS Catherine Wynne and Bill Humphrey Principals of Entrust New Direction IRA Catherine Wynne is best known as a dynamic speaker and expert on self-directed retirement investing. Her teaching credentials include the University of Denver Law School's Graduate Tax Program, Lorman Education and multiple CE certified courses for real estate brokers and CPAs. She has extensive personal experience as a real estate investor and syndicator and is recognized regionally as an expert in the IRS rules for IRA investment. She is an author of industry articles and courses on the subject of non-traditional IRA investment and has an instructional book currently in the works. She understands that paying attention to the details of investments as well as the IRS rules is what makes self-direction work. Working primarily in client asset acquisition, she is well acquainted with the IRA purchase of a wide variety of assets such as mortgages, notes, real estate, private placements and LLCs. Catherine has a BS in Structural Engineering from the University of Pittsburgh and spent the first part of her career in oil and gas production, later moving into nuclear power plant design with Westinghouse. Bill Humphrey is recognized by professional advisors as an expert in the self-direction of IRAs and other tax-advantaged accounts as well as the associated IRS codes pertaining to these investments. Bill is also an experienced Certified Public Accountant who, over the past 20 years, has specialized in tax- 21

23 related property issues and forensic accounting. He received his BS in Business from the University of North Carolina, Chapel Hill. Bill's graduate work included a concentration in finance and economics. He knows the ins-and-outs of IRA law and stays current with all legislation governing tax-deferred or tax-free retirement arrangements. Bill has also been a consultant to the HSA Insider, one of the largest clearinghouses of Health Savings Account information on the web. He became involved in real estate investing with his associate, Catherine Wynne, and assisted in developing the framework for debt-leveraged IRA real estate investment. 22

24 Appendix A IRS Code Section 4975 Prohibited Transactions IRS Regulations Sec Tax on prohibited transactions US Code as of: 01/05/99 (a) Initial taxes on disqualified person There is hereby imposed a tax on each prohibited transaction. The rate of tax shall be equal to 15 percent of the amount involved with respect to the prohibited transaction for each year (or part thereof) in the taxable period. The tax imposed by this subsection shall be paid by any disqualified person who participates in the prohibited transaction (other than a fiduciary acting only as such). (b) Additional taxes on disqualified person In any case in which an initial tax is imposed by subsection (a) on a prohibited transaction and the transaction is not corrected within the taxable period, there is hereby imposed a tax equal to 100 percent of the amount involved. The tax imposed by this subsection shall be paid by any disqualified person who participated in the prohibited transaction (other than a fiduciary acting only as such). (c) Prohibited transaction o (1) General rule For purposes of this section, the term "prohibited transaction" means any direct or indirect - (A) sale or exchange, or leasing, of any property between a plan and a disqualified person; (B) lending of money or other extension of credit between a plan and a disqualified person; (C) furnishing of goods, services, or facilities between a plan and a disqualified person; (D) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan; (E) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account; or (F) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan. o (2) Special exemption The Secretary shall establish an exemption procedure for purposes of this subsection. Pursuant to such procedure, he may grant a conditional or unconditional exemption of any disqualified person or transaction, orders of disqualified persons or transactions, from all or part of the restrictions imposed by paragraph (1) of this subsection. Action under this subparagraph may be taken only after consultation and coordination with the Secretary of Labor. The Secretary may not grant an exemption under this paragraph unless he finds that such exemption is - (A) administratively feasible, (B) in the interests of the plan and of its participants and beneficiaries, and (C) protective of the rights of participants and beneficiaries of the plan. Before granting an exemption under this paragraph, the Secretary shall require adequate notice to be given to interested persons and shall 23

25 o o o publish notice in the Federal Register of the pendency of such exemption and shall afford interested persons an opportunity to present views. No exemption may be granted under this paragraph with respect to a transaction described in subparagraph (E) or (F) of paragraph (1) unless the Secretary affords an opportunity for a hearing and makes a determination on the record with respect to the findings required under subparagraphs (A), (B), and (C) of this paragraph, except that in lieu of such hearing the Secretary may accept any record made by the Secretary of Labor with respect to an application for exemption under section 408(a) of title I of the Employee Retirement Income Security Act of (3) Special rule for individual retirement accounts An individual for whose benefit an individual retirement account is established and his beneficiaries shall be exempt from the tax imposed by this section with respect to any transaction concerning such account (which would otherwise be taxable under this section) if, with respect to such transaction, the account ceases to be an individual retirement account by reason of the application of section 408(e)(2)(A) or if section 408(e)(4) applies to such account. (4) Special rule for medical savings accounts An individual for whose benefit a medical savings account (within the meaning of section 220(d)) is established shall be exempt from the tax imposed by this section with respect to any transaction concerning such account (which would otherwise be taxable under this section) if section 220(e)(2) applies to such transaction. (5) Special rule for education individual retirement accounts An individual for whose benefit an education individual retirement account is established and any contributor to such account shall be exempt from the tax imposed by this section with respect to any transaction concerning such account (which would otherwise be taxable under this section) if section 530(d) applies with respect to such transaction. (d) Exemptions Except as provided in subsection (f)(6), the prohibitions provided in subsection (c) shall not apply to - o (1) any loan made by the plan to a disqualified person who is a participant or beneficiary of the plan if such loan - (A) is available to all such participants or beneficiaries on a reasonably equivalent basis, (B) is not made available to highly compensated employees (within the meaning of section 414(q)) in an amount greater than the amount made available to other employees, (C) is made in accordance with specific provisions regarding such loans set forth in the plan, (D) bears a reasonable rate of interest, and (E) is adequately secured; o (2) any contract, or reasonable arrangement, made with a disqualified person for office space, or legal, accounting, or other services necessary for the establishment or operation of the plan, if no more than reasonable compensation is paid therefore; o (3) any loan to an [1] leveraged employee stock ownership plan (as defined in subsection (e)(7)), if - [1] So in original. Probably should be "a". (A) such loan is primarily for the benefit of participants and beneficiaries of the plan, and (B) such loan is at a reasonable rate of interest, and any collateral which is given to a disqualified person by the plan consists only of qualifying employer securities (as defined in subsection (e)(8)); o (4) the investment of all or part of a plan's assets in deposits which bear a reasonable interest rate in a bank or similar financial institution supervised by the United States or a State, if such bank or other institution is a fiduciary of such plan and if

26 o o o o o (A) the plan covers only employees of such bank or other institution and employees of affiliates of such bank or other institution, or (B) such investment is expressly authorized by a provision of the plan or by a fiduciary (other than such bank or institution or affiliates thereof) who is expressly empowered by the plan to so instruct the trustee with respect to such investment; (5) any contract for life insurance, health insurance, or annuities with one or more insurers which are qualified to do business in a State if the plan pays no more than adequate consideration, and if each such insurer or insurers is - (A) the employer maintaining the plan, or (B) a disqualified person which is wholly owned (directly or indirectly) by the employer establishing the plan, or by any person which is a disqualified person with respect to the plan, but only if the total premiums and annuity considerations written by such insurers for life insurance, health insurance, or annuities for all plans (and their employers) with respect to which such insurers are disqualified persons (not including premiums or annuity considerations written by the employer maintaining the plan) do not exceed 5 percent of the total premiums and annuity considerations written for all lines of insurance in that year by such insurers (not including premiums or annuity considerations written by the employer maintaining the plan); (6) the provision of any ancillary service by a bank or similar financial institution supervised by the United States or a State, if such service is provided at not more than reasonable compensation, if such bank or other institution is a fiduciary of such plan, and if - (A) such bank or similar financial institution has adopted adequate internal safeguards which assure that the provision of such ancillary service is consistent with sound banking and financial practice, as determined by Federal or State supervisory authority, and (B) the extent to which such ancillary service is provided is subject to specific guidelines issued by such bank or similar financial institution (as determined by the Secretary after consultation with Federal and State supervisory authority), and under such guidelines the bank or similar financial institution does not provide such ancillary service - (i) in an excessive or unreasonable manner, and (ii) in a manner that would be inconsistent with the best interests of participants and beneficiaries of employee benefit plans; (7) the exercise of a privilege to convert securities, to the extent provided in regulations of the Secretary but only if the plan receives no less than adequate consideration pursuant to such conversion; (8) any transaction between a plan and a common or collective trust fund or pooled investment fund maintained by a disqualified person which is a bank or trust company supervised by a State or Federal agency or between a plan and a pooled investment fund of an insurance company qualified to do business in a State if - (A) the transaction is a sale or purchase of an interest in the fund, (B) the bank, trust company, or insurance company receives not more than a reasonable compensation, and (C) such transaction is expressly permitted by the instrument under which the plan is maintained, or by a fiduciary (other than the bank, trust company, or insurance company, or an affiliate thereof) who has authority to manage and control the assets of the plan; (9) receipt by a disqualified person of any benefit to which he may be entitled as a participant or beneficiary in the plan, so long as the benefit is computed and paid on a basis which is consistent with the terms of the plan as applied to all other participants and beneficiaries; 25

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